Interest-rate Swaps Scream “Buyer Beware”

The Financial Services Authority found that some U.K. banks misled corporate customers in the sales of interest-rate swaps, but the problem is not confined to one country.

While few CFOs or treasurers would relish the idea of boning up on interest-rate swaps, it now seems as if someone in the finance department ought to.

Many businesses may have been misled about the costs and risks of interest-rate hedging products they bought from U.K. banks in the past decade, according to a preliminary review by the country’s Financial Services Authority released Thursday. In particular, the FSA found instances in which nonfinancial businesses it classifies as “unsophisticated” buyers were persuaded that they had to buy an interest-rate swap when they took out a loan, and many were unaware of the exorbitant costs of canceling an over-the-counter swap contract with a bank.

But experts say the sales practices that violated U.K. laws have occurred and may still be occurring worldwide — including in the United States.

Some examples: an Indian property developer, Unitech Ltd., sued Deutsche Bank AG last May for selling an interest-rate swap that Unitech says wasn’t explained properly. Jefferson County, Alabama, barely avoided bankruptcy after entering into $5.6 billion of swap trades in which the fees were embedded in the interest rates the county paid, hiding the fact that the county was substantially overcharged by its bank.

Many companies, including U.S. businesses, are buying interest-rate hedges, usually in conjunction with borrowing, that they just don’t comprehend, can’t value, and that contain hidden fees and risks.

“I think the end-user can enter into a deal without fully understanding it, and I have seen situations like this over the years,” says Gurpreet Banwait, product manager at derivatives risk-management firm FINCAD. “I’m no longer surprised at [the deals] people execute.”

Interest-rate swaps — which financial-services providers consider relatively simple instruments — aren’t always that simple for end-users to fathom. To a borrower, a swap instrument may look good because there are no upfront fees or even perhaps a positive return. But “this is usually achieved through complexity that only the seller truly understands,” says Banwait.

As part of a pilot study of the sale of 40,000 interest-rate hedging products over a decade, the FSA said it looked at 173 swap sales to nonsophisticated customers from four banks: Barclays Bank Plc, HSBC Bank Plc, Lloyds Banking Group, and the Royal Bank of Scotland. It found that more than 90% of the sales did not comply with one or more U.K. regulatory requirements regarding sales practices, such as the failure to ascertain the customers’ understanding of risk. Instances of “overhedging” — where a swap’s amount or duration does not match the underlying loan — were also found.

In other deals, borrowers were misled into thinking that buying a hedge was mandatory. The FSA found an instance in which a business that didn’t want to buy an interest-rate hedge was told by the bank that “it was a requirement of their loan that they purchase the product.”

“Break,” or exit, costs were another area of confusion. When exiting a swap, the customer or the bank may have to make a payment to the counterparty, depending on market conditions. But the FSA found that in a high proportion of swap sales, customers weren’t given enough information to figure out the cost of exiting. “We saw examples in the pilot where the break cost exceeded 40% of the value of the underlying loan,” the FSA said in its report.

In one case, a business purchased a swap in which the bank had the option to exit the deal after five years. The customer said it was misled into believing it too could exit the contract after the same time period without any costs “when this was not the case,” said the FSA.

In the United States, of course, exiting a bilateral swap is just as costly and complex. To get out of such a swap, a company would have to sell the swap back to the bank, offload it to a third party, or enter into a swap that offsets the original instrument. “In general, terminating an [OTC] swap creates difficulty, friction, and increased costs,” Sean Tully, head of interest rates at CME Group, told CFO last December.

Despite what may be deceptive sales practices by financial institutions, it’s not all up to the bank to explain an OTC derivative, Banwait points out. The borrower “needs to increase its knowledge of derivatives in order to match that of the seller. We have seen how that inequity has produced some negative consequences over the years,” he says. “If you’re looking to hedge something very specific, then the corresponding derivative or instrument is going to be complex.”

The Securities and Exchange Commission and the Commodity Futures Trading Commission are still at work hammering out new Dodd-Frank rules governing the requirement that OTC swap facilities be centrally cleared, as well as how to determine “eligible contract participants”: the kinds and size of businesses that will be allowed to enter into swap contracts. The ECP rules are not expected to severely limit access to swaps.

Bankers are waiting. The U.S.-based American Bankers Assn. says financial institutions need clarity on who will qualify as ECPs in order to extend credit to some businesses. “Loan officers are already lacking key guidance . . . that they need to ensure potential customers can continue using swaps to hedge and mitigate loan risk,” the ABA said in a letter to the CFTC and the SEC last August. “In the absence of guidance, the uncertainty is already causing some banks to reconsider whether borrowers with limited cash flows will have the ability, without swaps, to service debt should interest rates rise.”

Meanwhile, in the United Kingdom, findings from the pilot review of swap sales at seven other banks will be revealed by the FSA in the coming weeks. U.K. business customers will eventually be compensated if their bank is proven to have acted deceptively. Barclays, HSBC, Royal Bank of Scotland, and Lloyds have set aside £700 million ($1.1 billion) to cover the costs of compensating harmed customers.

When the FSA determines that a customer would not have bought the interest-rate product if the bank had followed proper disclosure and customer-suitability rules, it could order that the company be allowed to exit the product at no charge and be refunded all payments. According to the British Banker’s Assn., the banks have pledged to suspend ongoing swap payments from customers that are in financial distress, pending the outcome of reviews.